Capitalizing on silver’s slide with options

Precious metals enjoyed a seemingly endless summer during the faltering early stages of the global economic recovery. As central banks pumped cheap money into their respective economies, investors became progressively more wary of the much-heralded inflation that was supposed to accompany these massive liquidity injections. That inflation is looking far less likely to materialize, and metals bubbles have rapidly deflated as investors look to make the shift into now-high yielding equities.

Silver has been the single worst performing component of the Standard and Poor's GSCI gauge of commodities year-to-date, and no macroeconomic data, regardless of how bleak, seems enough to pull silver out of its slump. Even yesterday’s announcement of lower-than-projected quarterly GDP growth did nothing to aid the metal, as a modest bump at the time of the announcement was followed by an accelerated slide. Silver yesterday reached $18.45, its lowest point since August 2010, which represents a quarterly decline of approximately 34%. This is the steepest fall in silver’s value since the Hunt brothers’ failed cornering of the market in 1980.

This morning’s economic data was positive, and silver again seems unable to find a foothold amidst climbing equity values and improving yields in other market sectors. It would be unwise to call a bottom in this or any other inflation-hedge vehicle at this time, as the approaching Federal Reserve taper will, in the event that it occurs on schedule, clear up most residual hyperinflation fears. Economic uncertainty is a boon to silver prices, and as conditions become more certain and more optimism is espoused by Ben Bernanke and his board of governors the price of silver is bound to fall further.

So what are the different ways a trader can trade silver prices?

Spot silver. The most direct exposure to the price of silver, but a very capital intensive venture.

The ETF. SLV does a good job of tracking the movement in silver prices, but this is also a capital intensive trade.

Options on silver futures (SI). The best and most accurate way to set up a trade with a good risk vs. reward setup. The inherent leverage of options on futures also allows a trader to take on a position without risking a large amount of capital.

With the December silver futures currently trading at $18.845, the October at-the-money straddle is implying a move of $2.51 to the upside or downside by October expiration. This gives us a downside measured move target of $16.335. This would be a level below the three-year lows in silver and a rather aggressive target. Luckily we can use options to set up a great profit potential with a more conservative target.

Trade: Buying the /SI Oct 17.75-17.25 Put Spread for 0.15

Risk: $750 per 1 lot

Reward: $1,750 per 1 lot

Breakeven: $17.60

This trade sets up a good reward to risk ratio should silver futures test their three-year lows. With the strong downward momentum recently, this is a very real possibility.

Click to enlarge.

About the Author

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.